Investing in fragile states: What makes a great frontier market fund manager?

By Naki B. Mendoza 22 April 2016

A view of busy downtown Kampala in Uganda, one of the countries in Sub-Saharan Africa where IFC is supporting small and midsize enterprises under the initiative SME Ventures, which targets investments in frontier markets. Photo by: Babak Fakhamzadeh / CC BY-NC

In development finance, there’s private equity and there’s private equity in fragile states.

Both share the same objective — large returns on vast sums of capital invested in high-growth markets, typically meaning developing countries. But the latter requires a unique investment approach and poses distinct, often vexing, challenges, even for financial institutions with a mandate for development.

“These are tough markets,” said Tracy Washington, an investment officer with the International Finance Corp., the private sector investment arm of the World Bank. “They’re not for the faint of heart.”

Private equity is inherently risky business. The double-digit returns that the typical multibillion dollar fund seeks necessitates large gambles, but the upside entails handsome earnings from commercial innovations and booming business models that, in turn, can allow developing economies to flourish.

Not business as usual

While private equity often targets developing countries, the risks are magnified in the subsets Washington refers to since the infrastructure to support those investments is sorely lacking. They are frontier markets with weak, if any, regulatory frameworks for financial investments. Most have never previously supported structured investments, and many have recently emerged from some form of conflict.

In 2007 the IFC made the largest profit in its then 50-year history. The following year its board challenged the IFC, already one of the largest private equity investors in emerging markets, to take more risk with those earnings. It led to a string of initiatives that support business in frontier markets and fragile states through direct investments, technical assistance and advisory services.

The initiative that Washington heads, SME Ventures, has set up five funds that invest in small and midsize enterprises deemed to have strong growth potential in a range of frontier markets. Most are in sub-Saharan Africa — Burundi, Central African Republic, Democratic Republic of the Congo, Liberia, Sierra Leone and Uganda — but the funds also invest in Bangladesh and Nepal.

“Private equity in Africa has arrived when it comes to Kenya, Nigeria and South Africa,” Washington told Devex, but outside of that big three, private equity on the continent is still in nascent stages, she noted.

One reason is because the sheer size of private equity capital often gravitates toward larger tiered projects and companies such as those in power or infrastructure, for example. But in many frontier markets, companies of that size and scale simply don’t exist.

The market structure in those countries requires a new approach, particularly for an entity like the IFC that’s often looked on to be an anchor investor in fragile markets.

“The real challenge is the missing middle,” Washington said, noting that rather than the billion dollars investments in large companies, the focus is on the $1 [million] to $5 million dollar investments in SMEs. “That’s the space we’re trying to create fund managers to fill.”

It means targeting much more basic services to meet local consumer demand. In Sierra Leone, for example, an IFC fund invested in a water bottling facility. And in Liberia, a fund invested in the first commercial bakery since the end of the country’s civil war.

User’s guide

The IFC has created a loose set of best practices around its approach — rough guidelines to help them and other investors navigate the risks of frontier and fragile markets.

Much of it revolves around the skills of the fund manager.

It is essential in almost all cases for fund managers to have a local presence to better inform their investment decisions, especially since in many countries private equity due diligence is not business as usual.

“The regulatory framework is missing, there are no credit bureaus, feasibility studies don’t exist and private equity is often not well understood by the [local] central bank,” said Michel Botzung, an IFC investment manager focusing on fragile and conflict states. “You have to do your own risk assessment based on intangible data.”

The “fly-in, fly-out” culture typical of white collar finance, in which fund managers fly from London or New York to close large transactions, doesn’t cut it in a frontier Africa environment, Botzung warned: “You have to plow the market by your presence on the ground to understand the dynamics in order to take a reasonable risk.”

Since investments largely focus on consumer services and industries such as manufacturing, tourism, logistics or transportation, fund managers should also have significant operations experience, according to the IFC.

“It’s essential to have strong local networks and to understand what will get them access to markets,” Washington said.

The types of deals in fragile states tend to differ from traditional private equity, so for fund managers a broad knowledge of different financial instruments is also a must. Exit strategies in fragile states are much less clear than in other private equity markets for a host of reasons, from the absence of stock markets to a lack of firms with the capacity to buy large assets. Most deals, therefore, are structured as “upside loans” rather than pure equity, usually combining fixed payments with some form of royalties or revenues.

Certain soft skills and mindsets also lend themselves to a good frontier market fund manager. Does the fund manager show a commitment to two years of fundraising? Do they have another income stream while fundraising? Have they demonstrated shifts in their lives to take on these burdens?

“These are tricky questions in the professional world … but persistence, commitment and tenacity are all key,” Washington told Devex.

And perhaps above all: expect the unexpected. Beyond the systemic risks of weak regulations and opaque data that can affect any investment, Washington noted that every one of the countries that the IFC’s SME Ventures invests in has suffered some sort of a macro-shock. An earthquake in Nepal. Ebola in Liberia and Sierra Leone. A coup in the Central African Republic. All of these events underscore the imperative for fund managers to maintain resilient networks and make steady decisions during times of crisis.

Africa, many investors believe, is poised for breakneck growth for a number of reasons. The continent has significant room for development, is rich in natural resources and is endowed with a demographic dividend — approximately half of its 1 billion people are under the age of 20.

But despite the enthusiasm for that potential, the IFC says it has been a tough challenge attracting outside investment into the space of fragile state SMEs. Since its launch in 2008 — when investors worldwide were pulling back — the IFC has gone in alone on several fund investments, leaving it highly exposed in risky markets.

“It has been a lonely space up until now,” Washington said. “We really need other impact investors, donors and development finance institutions to step up and prioritize some of these tougher markets.”

SME Ventures is invested in 70 companies with $40 million of committed capital. The funds are still within their 10-year investment window, but anticipated returns are in the low double digits. Despite the obstacles, the IFC agreed in August 2015 to expand the number of SME Venture funds from five to 20 over the next five years. The target is part of a broader goal to double its investments in fragile states to roughly six percent of its total loan portfolio by 2018.

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About the author

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Naki B. Mendozamfbmendoza

Naki is a reporter for Devex Impact based in Washington, D.C., where he covers the intersection of business and international development. Prior to Devex he was a Latin America reporter for Energy Intelligence covering corporate investments and political risks in the region’s energy sector. His previous assignments abroad have posted him throughout Europe, South America and Australia.


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